Thursday, September 05, 2013

Sweden's Krugman Wrong About Debt

Lars E.O. Svensson, former member of the board of Sweden's central bank, the Riksbank, and also former colleague of Paul Krugman at Princeton University, is the most prominent advocate of a more inflationist monetary policy in Sweden. One might say that he is "Sweden's Krugman".

While being in the Riksbank board, he publicly criticized his colleagues for not being more inflationist, arguing that higher interest rates was an inappropriate way of reducing household debt while lower interest rates was an appropriate way of reducing unemployment. After he left the board he has continued to argue for more inflation, now with the new argument that a tighter monetary policy will actually increase the household debt burden in the short term and even in the long term will only leave it unchanged. That is because according to his model, it will reduce nominal GDP, and nominal household income, more than it will reduce nominal household debt

If you go through his actual paper, which isn't easy for everyone since it contains a lot of greek letters and related advanced mathematical expressions, you can see that the results in his theoretical model rests on two assumptions:

1) Interest rates has no effect on amortization or the use of value increases on their houses to increase their mortgage.
2) Interest rates only lowers or increases the issuance of new mortgages by the same relative proportion that it lowers or increases nominal income.

Of course, if these assumptions had been true then it would have indeed followed that a tighter monetary policy would raise the debt to income ratio and that a more inflationary would reduce it.

However, both assumptions are in fact wrong. If house prices are lowered then this will clearly greatly reduce or eliminate the possibility of getting a higher mortgage using the value of the house as collateral and higher interest rates will make home owners (and other debtors) more eager to amortize. Higher interest rates will also reduce the issuane of new mortgages (and other forms of debt) more than it reduces nominal income because of the substitution effect from higher interest rates.

And because both key assumptions are wrong, his conclusion is also wrong

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